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McDonnell: How to Measure Risk When Writing Options

Many novice traders think only in terms of potential profit. They fail to think about the risk inherent in every trade. In my opinion the risk is the most important factor to consider in trading.

There are many ways to measure risk when we are selling options. One is simply to look at the delta; another is to calculate the probability that the option will expire worthless. One of the metrics I always look at is the margin of safety. Let us talk about each of these risk metrics and understand the advantages and limitations of each.

Delta. The delta is the Greek measure of how an option will move with respect to the stock. For example if the delta of an at the money put is -0.50 then that put will move -0.50 for every point up that the stock moves. If you are bullish on the stock then the delta of -0.50 says the position is like being long 50 shares of the stock. If you sell a put with a delta of -0.10 it has about the risk profile of being long 10 shares of stock.

Delta is a good metric of option risk and should always be considered. However, it has some limitations which all option traders should understand. First the delta can change as the stock moves. As the stock moves toward the money the delta will increase. If the stock is at the money the delta should be about 0.50 (-0.50 for a put). When the stock is out of the money the option delta should be lower.

Another limitation of the delta is that if the option deltas on two stocks are both 0.50 they may not be equally volatile. Strictly speaking, the right way to look at delta is to multiply the delta times the beta for the stock. That will correctly adjust for the volatility of the underlying stock.

Probability. One of the measures that I like to look at is the probability that the option will expire worthless. This is the hoped for outcome if we are selling an option. We want the option to expire so we can keep the entire premium without having to give any back. As option sellers the probability of success is higher than if we simply bought or sold the stock. This is because we receive premium that puts us ahead of the game and earn theta erosion as time passes. In order to lose at all we would need to lose at least the amount of the premium at expiration.

The limitation of probability is that it does not tell the whole story. It does not take into account how much could be won or lost at various prices. Despite that limitation it is still a great measure to estimate our risk of losing.

Margin of Safety. This is a simple measure of how likely we are to lose. I call it the margin of safety. It is as simple as calculating the difference between the current stock price and the strike price for the option in question. If this difference is at least 10% of the strike price then the margin of safety is probably sufficient. Of course a 20% margin is even better, but as you get further out of the money the return on margin will drop and may be unacceptably low. As a general rule of thumb you want to have a large safety margin on a more volatile stock.